Is Microfinance the New Subprime?

Is microfinance the new subprime? We’ve been hearing that portentous analogy for years, and now that the Indian state of Andhra Pradesh is riveting the world with stories of loan-shark-style microfinanciers driving borrowers to suicide, the claim has taken on fresh currency. Considering the industry’s growing commercialization, it is an obvious comparison to draw. But the most obvious metaphors are not always the most appropriate ones, and sloppy metaphors can easily drive bad policy.

For sure, there are some real similarities between microfinance in India today and the pre-crisis subprime mortgage market in the U.S, and we can learn from them. As microfinance institutions have quickly grown, profit-seeking money has flooded into the sector. Loans to poor households have kept pace, with the number of borrowers surging from 8 million to more than 20 million over the past three years.

With this growth, some borrowers have gotten in over their heads. Press accounts offer sensational stories of borrowers pressured to take out one loan to pay off another falling even deeper into the chasm of debt. While it is difficult to discern reality in Andhra Pradesh, given the tangle of political and business interests at play, we can’t dismiss the fact that people in India, just like people in the U.S., want to be better off. When resources are available, they will take advantage — and some will go too far, whether driven by pushy salesmen or their own desires. This is inherent in finance, which is why any system, not just one that is rapidly commercializing, needs safeguards, like ways to monitor over-indebtedness.

This can be difficult to see when it comes to microfinance, because, much as with the subprime market in the U.S., there is an ideological underpinning that makes us want to believe nothing too bad can happen. In the U.S., owning a house is considered a fundamental part of the American Dream. Similarly, microfinance promises to change lives, to help people lift themselves out of poverty. Microfinance brings empowerment and dignity, we tell ourselves. And who could be against dignity? The U.S. certainly could have used some pushback on its ideology and perhaps the same can be said of microfinance today.

But while it may be useful to draw some comparisons to the U.S. subprime debacle, India’s experience is drastically different in significant ways.

To start, we should recognize that Andhra Pradesh is in a much less precarious position than the U.S. was a few years ago, when an entire nation was caught up in the delusion that house prices would never stop their steep ascent. Most of the complaints about the microfinance sector in India come back to unscrupulous practices like loan officers talking borrowers into taking on too much debt and collection agents being coercive. These are serious allegations and the government of Andhra Pradesh has smartly moved to ban strong-arming, increase disclosure about loan costs, and control the number of loans one person can receive. But the core of the problem is at least not a profound misunderstanding and misuse of most families’ largest asset.

Another important contrast follows from the fact that the U.S. subprime mortgage industry was built on a fundamentally different equation — and a fundamentally different pathology. At the heart of the subprime crisis was risk-based pricing. Thanks to credit scores, lenders had elaborate knowledge about any given individual’s likely ability to repay a loan; the game was not to just lend to those who could repay, but to price loans sufficiently high to cover the costs of those who were expected to default. The premise of microfinance is at the other end of the spectrum: lenders intend to recapture every dollar they loan out and take great pride in the high percentage of loans repaid.

It is easy to compare a high interest rate on a subprime mortgage to a high interest rate on a microfinance loan, but these two rates come from very different philosophies about how to make money from extending credit. In the case of microfinance, if anything, the problem rests with an overly obsessive pursuit of perfect loan repayments. The relatively high prices for microfinance loans (beginning at about 25% on an annualized basis) largely reflect the high costs of small-scale transactions in a labor-intensive business. Microfinance interest rates in India are already falling in the wake of this month’s crisis; slashing them further through stringent usury laws will undermine an industry which holds the promise to do substantial good. In that light, last week’s microfinance law capping interest rates at 24% per year in Andhra Pradesh strikes a laudable balance between the interests of populist politicians versus lenders trying to keep businesses afloat.

The most important distinction between microfinance and subprime mortgage lending is that most microfinance institutions got their start through an impulse to create opportunities for unbanked and excluded citizens. Embedded in the institutions’ DNA is a desire to do right by the world, not just make money off of it. Commercialization may be changing the industry — sometimes too fast and creating conflicting interests — but there are still plenty of good people involved who are open to having thoughtful conversations. Many argue that microfinance in India is now “too big to fail.” Perhaps, but the industry is not too far removed from the lives of poor Indians to care deeply about the direction things head from here.